Panel Unit Root Tests in the Presence of a Multifactor Error Structure

This paper extends the cross sectionally augmented panel unit root test proposed by Pesaran (2007) to the case of a multifactor error structure. The basic idea is to exploit information regarding the unobserved factors that are shared by other time series in addition to the variable under consideration. Importantly, our test procedure only requires specification of the maximum number of factors, in contrast to other panel unit root tests based on principal components that require in addition the estimation of the number of factors as well as the factors themselves. Small sample properties of the proposed test are investigated by Monte Carlo experiments, which suggest that it controls well for size in almost all cases, especially in the presence of serial correlation in the error term, contrary to alternative test statistics. Empirical applications to Fisher’s inflation parity and real equity prices across different markets illustrate how the proposed test works in practice

Long Run Macroeconomic Relations in the Global Economy

This paper focuses on testing long run macroeconomic relations for interest rates, equity, prices and exchange rates within a model of the global economy. It considers a number of plausible long run relationships suggested by arbitrage in financial and goods markets, and uses the global vector autoregressive (GVAR) model in Dees, di Mauro, Peseran and Smith (2007) to test for long run restrictions in each country/region conditioning on the rest of the world. Bootstrapping is used to compute both the empirical distribution of the impulse responses and log-likelihood ratio statistic for over-identifying restrictions. The paper also examines the speed with which adjustments to the long tun relations take place via the persistence profiles. We find strong evidence in favour of the uncovered interest parity and to a lesser extent the Fisher equation across a number of countries, but our results for the PPP are much weaker. Also as to be expected, the transmission of shocks and subsequent adjustments in financial markets are much faster than those in goods markets

Panel Unit Root Tests in the Presence of a Multifactor Error Structure

This paper extends the cross sectionally augmented panel unit root test proposed by Pesaran (2007) to the case of a multifactor error structure. The basic idea is to exploit information regarding the unobserved factors that are shared by other time series in addition to the variable under consideration. Importantly, our test procedure only requires specification of the maximum number of factors, in contrast to other panel unit root tests based on principal components that require in addition the estimation of the number of factors as well as the factors themselves. Small sample properties of the proposed test are investigated by Monte Carlo experiments, which suggest that it controls well for size in almost all cases, especially in the presence of serial correlation in the error term, contrary to alternative test statistics. Empirical applications to Fisher’s inflation parity and real equity prices across different markets illustrate how the proposed test works in practice.panel unit root tests, cross section dependence, multi-factor residual structure, Fisher inflation parity, real equity prices

Forecasting Economic and Financial Variables with Global VARs

This paper considers the problem of forecasting real and financial macroeconomic variables across a large number of countries in the global economy. To this end a global vector autoregressive (GVAR) model previously estimated over the 1979Q1-2003Q4 period by Dees, de Mauro, Pesaran, and Smith (2007), is used to generate out-of-sample one quarter and four quarters ahead forecasts of real output, inflation, real equity prices, exchange rates and interest rates over the period 2004Q1-2005Q4. Forecasts are obtained for 134 variables from 26 regions made up of 33 countries covering about 90% of world output. The forecasts are compared to typical benchmarks: univariate autoregressive and random walk models. Building on the forecast combination literature, the effects of model and estimation uncertainty on forecast outcomes are examined by pooling forecasts obtained from different GVAR models estimated over alternative sample periods. Given the size of the modeling problem, and the heterogeneity of economies considered — industrialised, emerging, and less developed countries — as well as the very real likelihood of possibly multiple structural breaks, averaging forecasts across both models and windows makes a significant difference. Indeed the double-averaged GVAR forecasts performed better than the benchmark competitors, especially for output, inflation and real equity prices.forecasting using GVAR, structural breaks and forecasting, average forecasts across models and windows, financial and macroeconomic forecasts

What if the UK had Joined the Euro in 1999? An Empirical Evaluation Using a Global VAR

This paper attempts to provide a conceptual framework for the analysis of counterfactual scenarios using macroeconometric models. As an application we consider UK entry to the euro. Entry involves a long-term commitment to restrict UK nominal exchange rates and interest rates to be the same as those of the euro area. We derive conditional probability distributions for the difference between the future realisations of variables of interest (e.g UK and euro area output and prices) subject to UK entry restrictions being fully met over a given period and the alternative realisations without the restrictions. The robustness of the results can be evaluated by also conditioning on variables deemed to be invariant to UK entry, such as oil or US equity prices. Economic interdependence means that such policy evaluation must take account of international linkages and common factors that drive fluctuations across economies. In this paper this is accomplished using the Global VAR recently developed by Dees, di Mauro, Pesaran and Smith (2005). The paper briefly describes the GVAR which has been estimated for 25 countries and the euro area over the period 1979-2003. It reports probability estimates that output will be higher and prices lower in the UK and the euro area as a result of entry. It examines the sensitivity of these results to a variety of assumptions about when and how the UK entered and the observed global shocks and compares them with the effects of Swedish entry.Global VAR (GVAR), counterfactual analysis, UK and Sweden entry to Euro

Long Run Macroeconomic Relations in the Global Economy

This paper focuses on testing long run macroeconomic relations for interest rates, equity, prices and exchange rates within a model of the global economy. It considers a number of plausible long run relationships suggested by arbitrage in financial and goods markets, and uses the global vector autoregressive (GVAR) model developed in Dees, di Mauro, Pesaran and Smith (2007) to test for long run restrictions in each country/region conditioning on the rest of the world. Bootstrapping is used to compute both the empirical distribution of the impulse responses and the log-likelihood ratio statistic for over-identifying restrictions. The paper also examines the speed with which adjustments to the long run relations take place via the persistence profiles. We find strong evidence in favour of the uncovered interest parity and to a lesser extent the Fisher equation across a number of countries, but our results for the PPP are much weaker. Also as to be expected, the transmission of shocks and subsequent adjustments in financial markets are much faster than those in goods markets.Global VAR, interdependencies, Fisher relationship, Uncovered Interest Rate Parity, Purchasing Power Parity, persistence profile, error variance decomposition

Identification of New Keynesian Phillips Curves from a Global Perspective

New Keynesian Phillips Curves (NKPC) have been extensively used in the analysis of monetary policy, but yet there are a number of issues of concern about how they are estimated and then related to the underlying macroeconomic theory. The first is whether such equations are identified. To check identification requires specifying the process for the forcing variables (typically the output gap) and solving the model for inflation in terms of the observables. In practice, the equation is estimated by GMM, relying on statistical criteria to choose instruments. This may result in failure of identification or weak instruments. Secondly, the NKPC is usually derived as a part of a DSGE model, solved by log-linearising around a steady state and the variables are then measured in terms of deviations from the steady state. In practice the steady states, e.g. for output, are usually estimated by some statistical procedure such as the Hodrick-Prescott (HP) filter that might not be appropriate. Thirdly, there are arguments that other variables, e.g. interest rates, foreign inflation and foreign output gaps should enter the Phillips curve. This paper examines these three issues and argues that all three benefit from a global perspective. The global perspective provides additional instruments to alleviate the weak instrument problem, yields a theoretically consistent measure of the steady state and provides a natural route for foreign inflation or output gap to enter the NKPC.New Keynesian Phillips Curve, identification, Global VAR (GVAR), trend-cycle decomposition

Identification of New Keynesian Phillips Curves from a Global Perspective

New Keynesian Phillips Curves (NKPC) have been extensively used in the analysis of monetary policy, but yet there are a number of issues of concern about how they are estimated and then related to the underlying macroeconomic theory. The first is whether such equations are identified. To check identification requires specifying the process for the forcing variables (typically the output gap) and solving the model for inflation in terms of the observables. In practice, the equation is estimated by GMM, relying on statistical criteria to choose instruments. This may result in failure of identification or weak instruments. Secondly, the NKPC is usually derived as a part of a DSGE model, solved by log-linearising around a steady state and the variables are then measured in terms of deviations from the steady state. In practice the steady states, e.g. for output, are usually estimated by some statistical procedure such as the Hodrick-Prescott (HP) filter that might not be appropriate. Thirdly, there are arguments that other variables, e.g.interest rates, foreign inflation and foreign output gaps should enter the Phillips curve. This paper examines these three issues and argues that all three benefit from a global perspective. The global perspective provides additional instruments to alleviate the weak instrument problem, yields a theoretically consistent measure of the steady state and provides a natural route for foreign inflation or output gap to enter the NKPC.Global VAR (GVAR), identification, New Keynesian Phillips Curve, Trend-Cycle decomposition

Exploring the International Linkages of the Euro Area: a Global VAR Analysis

This paper presents a global model linking individual country vector error-correcting models in which the domestic variables are related to the country-specific variables as an approximate solution to a global common factor model. This global VAR is estimated for 26 countries, the euro area being treated as a single economy. This paper proposes two important extensions of previous research (see Pesaran, Schuermann and Weiner, 2004). First, it provides a theoretical framework where the GVAR is derived as an approximation to a global unobserved common factor model. Also using average pair-wise cross-section error correlations, the GVAR approach is shown to be quite effective in dealing with the common factor interdependencies and international comovements of business cycles. Second, in addition to generalised impulse response functions, we propose an identification scheme to derive structural impulse responses. We focus on identification of shocks to the US economy, particularly the monetary policy shocks, and consider the time profiles of their effects on the euro area. To this end we include the US model as the first country model and consider alternative orderings of the US variables. Further to the US monetary policy shock, we also consider oil price, US equity and US real output shocks.Global VAR (GVAR), global interdependencies, global macroeconomic modeling, impulse responses

Supply, Demand and Monetary Policy Shocks in a Multi-Country New Keynesian Model

This paper estimates and solves a multi-country version of the standard DSGE New Keynesian (NK) model. The country-specific models include a Phillips curve determining inflation, an IS curve determining output, a Taylor Rule determining interest rates, and a real effective exchange rate equation. The IS equation includes a real exchange rate variable and a country-specific foreign output variable to capture direct inter-country linkages. In accord with the theory all variables are measured as deviations from their steady states, which are estimated as long-horizon forecasts from a reduced-form cointegrating global vector autoregression. The resulting rational expectations model is then estimated for 33 countries on data for 1980Q1-2006Q4, by inequality constrained IV, using lagged and contemporaneous foreign variables as instruments, subject to the restrictions implied by the NK theory. The multi-country DSGE NK model is then solved to provide estimates of identified supply, demand and monetary policy shocks. Following the literature, we assume that the within country supply, demand and monetary policy shocks are orthogonal, though shocks of the same type (e.g. supply shocks in different countries) can be correlated. We discuss estimation of impulse response functions and variance decompositions in such large systems, and present estimates allowing for both direct channels of international transmission through regression coefficients and indirect channels through error spillover effects. Bootstrapped error bands are also provided for the cross country responses of a shock to the US monetary policy.global VAR (GVAR), New Keynesian DSGE models, supply shocks, demand shocks, monetary policy shocks